Ch 5 Part 2

Price Level, Inflation, and

Deflation (1 of 26)
• The price level is the average level of prices and the
value of money.
• A persistently rising price level is called inflation.
• A persistently falling price level is called deflation.
• We are interested in the price level because we want to
1. Measure the inflation rate or the deflation rate
2. Distinguish between money values and real values of
economic variables.
 Price Level, Inflation, and
Deflation (2 of 26)
• Why Inflation and Deflation Are Problems
• Low, steady, and anticipated inflation or deflation is not a
problem.
• Unpredictable inflation or deflation is a problem because
it
 Redistributes income and wealth
 Lowers real GDP and employment
 Diverts resources from production
 Price Level, Inflation, and
Deflation (3 of 26)
• Unpredictable changes in the inflation rate redistribute
income in arbitrary ways between employers and
workers and between borrowers and lenders.
• A high inflation rate is a problem because it diverts
resources from productive activities to inflation
forecasting.
• From a social perspective, this waste of resources is a
cost of inflation.
• At its worse, inflation becomes hyperinflation—an
inflation rate that is so rapid that workers are paid twice
a day because money loses its value so quickly.
 Price Level, Inflation, and
Deflation (4 of 26)
• The Consumer Price Index
• The Consumer Price Index, or CPI, measures the average
of the prices paid by urban consumers for a “fixed”
basket of consumer goods and services.
 Price Level, Inflation, and
Deflation (5 of 26)
• Reading the CPI Numbers
• The CPI is defined to equal 100 for the reference base
period.
• Currently, the reference base period is 2002.
• That is, for the average CPI of the 12 months of 2002
equals 100.
• In June 2017, the CPI was 130.4.
• This number tells us that the average of the prices paid
by urban consumers for a fixed basket of goods was 30.4
percent higher in June 2017 than it was during 2002.
 Price Level, Inflation, and
Deflation (6 of 26)
• Constructing the CPI
• Constructing the CPI involves three stages:
 Selecting the CPI basket
 Conducting a monthly price survey
 Calculating the CPI
 Price Level, Inflation, and
Deflation (7 of 26)
• The CPI Basket
• The CPI basket is based on a consumer expenditure
survey conducted by Statistics Canada, which is
undertaken infrequently.
• Today’s CPI basket today is based on data collected in the
Consumer Expenditure Survey of 2015 and valued at
prices in January 2017.
 Price Level, Inflation, and
Deflation (8 of 26)
• Figure 5.6 illustrates the CPI
basket.
• Shelter is the largest
component.
• Transportation and food
and beverages are the next
largest components.
• The remaining components
account for 37 percent of
the basket.
 Price Level, Inflation, and
Deflation (9 of 26)
• The Monthly Price Survey
• Every month, Statistics Canada employees check the
prices of the goods and services in the CPI basket in the
major cities.
• Calculating the CPI
1. Find the cost of the CPI basket at base-period prices.
2. Find the cost of the CPI basket at current-period prices.
3. Calculate the CPI for the current period.
 Price Level, Inflation, and
Deflation (10 of 26)
• Let’s work an example of
the CPI calculation.
• In a simple economy,
people consume only
oranges and haircuts.
• The CPI basket is 10
oranges and 5 haircuts.
• The table also shows the
prices in the base period.
• The cost of the CPI basket
in the base period was $50.
 Price Level, Inflation, and
Deflation (11 of 26)
• Table 5.1(b) shows the
fixed CPI basket of goods.
• It also shows the prices in
the current period.
• The cost of the CPI basket
at current-period prices is
$70.
 Price Level, Inflation, and
Deflation (12 of 26)
• The CPI is calculated using the formula:
• CPI = (Cost of basket at current-period prices ÷ Cost of
basket at base-period prices)  100.
• Using the numbers for the simple example,
• CPI = ($70 ÷ $50)  100 = 140.
• The CPI is 40 percent higher in the current period than it
was in the base period.
 Price Level, Inflation, and
Deflation (13 of 26)
• Measuring the Inflation Rate
• The major purpose of the CPI is to measure inflation.
• The inflation rate is the percentage change in the price
level from one year to the next.
• The inflation rate equals:
• [(CPI this year − CPI last year) ÷ CPI last year]  100.
 Price Level, Inflation, and
Deflation (14 of 26)
• Figure 5.7 shows the relationship between the price level
and the inflation rate.
• Figure 5.7(a) shows the CPI from 1970 to 2017.
 Price Level, Inflation, and
Deflation (15 of 26)
• Figure 5.7(b) shows that the inflation rate is:
 High when the price level is rising rapidly
 Price Level, Inflation, and
Deflation (16 of 26)
 Low when the price level is rising slowly
 Negative when the price level is falling
 Price Level, Inflation, and
Deflation (17 of 26)
• The Biased CPI
• The CPI might overstate the true inflation for four
reasons:
 New goods bias
 Quality change bias
 Commodity substitution bias
 Outlet substitution bias
 Price Level, Inflation, and
Deflation (18 of 26)
• New Goods Bias
• New goods that were not available in the base year
appear and, if they are more expensive than the goods
they replace, they put an upward bias into the CPI.
• Quality Change Bias
• Quality improvements occur every year. Part of the rise
in the price is payment for improved quality and is not
inflation.
• The CPI counts all the price rise as inflation.
 Price Level, Inflation, and
Deflation (19 of 26)
• Commodity Substitution Bias
• The market basket of goods used in calculating the CPI is
fixed and does not take into account consumers’
substitutions away from goods whose relative prices
increase.
• Outlet Substitution Bias
• As the structure of retailing changes, people switch to
buying from cheaper sources, but the CPI, as measured,
does not take account of this outlet substitution.
 Price Level, Inflation, and
Deflation (20 of 26)
• The Magnitude of the Bias
• Estimates say that the CPI overstates inflation by 0.6
percentage points a year.
• Some Consequences of the Bias
 Distorts private contracts.
 Increases government outlays (close to a third of
federal government outlays are linked to the CPI).
• A bias of 0.6 percent is small, but over a decade adds up
to billions of dollars of additional expenditure.
 Price Level, Inflation, and
Deflation (21 of 26)
• Alternative Price Indexes
• Alternative measures of the price level are
 GDP deflator
 Chained price index for consumption (CPIP)
 Price Level, Inflation, and
Deflation (22 of 26)
• GDP Deflator
• The GDP deflator equals
• (Nominal GDP ÷ Real GDP)  100
• GDP deflator is a broader measure of the price level than
the CPI because it includes all final expenditure on
Canadian produced goods and services.
• But as a cost of living, the GDP deflator is too broad.
• Over the period 2000 to 2016, the GDP deflator
increased at an average rate of 1.9 percent a year, which
is 0.3 percentage points below the CPI inflation rate.
 Price Level, Inflation, and
Deflation (23 of 26)
• Chained Price Index for Consumption
• CPIC = (Nominal consumption expenditure ÷ Real
consumption expenditure)  100
• Because the GDP deflator and CPIC use current-period
and previous-period quantities, they and incorporate
substitution effects and new goods and overcome the
sources of bias in the CPI.
• From 2000 to 2016, CPIC increased at an average rate of
1.8 percent a year, which is 0.4 percentage points below
the CPI inflation rate.
 Price Level, Inflation, and
Deflation (24 of 26)
• Core Inflation Rate
• The core inflation rate excludes the volatile prices of the
CPI basket in an attempt to reveal the inflation trend.
• The Bank of Canada monitors three measures:
• The CPI-trim is the CPI excluding the top and bottom 20
percent most extreme price changes.
• The CPI-median measures inflation as the percentage
change in the middle items in the CPI basket.
• The CPI-common uses a statistical method to reveal the
most common price changes.
 Price Level, Inflation, and
Deflation (25 of 26)
• The Bank of Canada uses
the CPI-trim measure as its
measure of core inflation.
• The core inflation rate
removes most of the wide
swings in the CPI inflation
rate.
 Price Level, Inflation, and
Deflation (26 of 26)
• The Real Variables in Macroeconomics
• We can use the GPD deflator to deflate nominal variables
to find their real values.
• For example,
• Real wage rate = (Nominal wage rate ÷ GDP deflator)
100

• But not the real interest rate! It is different.